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ECN 106 Macroeconomics 1
Lecture 1
Giulio Fella
c© Giulio Fella, 2012 ECN 106 Macroeconomics 1 - Lecture 1 1/309
COURSE ORGANIZATION
I LECTURES: Once a week 15-17 in Mason Lecture Theatre
I CLASSES: Once a week, starting in week 2
I TEXTBOOK: G. Mankiw, Macroeconomics, 7th Inter-
national Edition, (Worth Publishers, 2010)
c© Giulio Fella, 2012 ECN 106 Macroeconomics 1 - Lecture 1 2/309
ASSESSMENT
I 2 mid-term tests administered during tutorial classes:
• Random date, announced in lectures the week before
• the average counts for 20% of the final mark
I Final exam: remaining 80%
c© Giulio Fella, 2012 ECN 106 Macroeconomics 1 - Lecture 1 3/309
COMMUNICATION AND COURSE WEBPAGE
I Course webpage: accessible on WebCT(http://www.elearning.qmul.ac.uk/webct)
• Lecture notes and problem sets available the Thursday
(evening) before the relevant lecture
I Interesting (optional) links:
http://www.diigo.com/list/giu123/macro1
c© Giulio Fella, 2012 ECN 106 Macroeconomics 1 - Lecture 1 4/309
Scope of this course
I What determines the level of output and employment both
in the short and the long run
I What is the effect of fiscal and monetary policies on
aggregate variables.
I Can policy exacerbate or dampen recessions and/or
expansions.
c© Giulio Fella, 2012 ECN 106 Macroeconomics 1 - Lecture 1 5/309
What is macroeconomics?
I Unlike microeconomics which studies the choices and
interaction of individual agents (e.g. consumers and firms),
macroeconomics is the study of the economy in the
aggregate.
I Macroeconomics is about general equilibrium; i.e.
interaction between (some) markets.
c© Giulio Fella, 2012 ECN 106 Macroeconomics 1 - Lecture 1 6/309
What is macroeconomics?
I Unlike microeconomics which studies the choices and
interaction of individual agents (e.g. consumers and firms),
macroeconomics is the study of the economy in the
aggregate.
I Macroeconomics is about general equilibrium; i.e.
interaction between (some) markets.
c© Giulio Fella, 2012 ECN 106 Macroeconomics 1 - Lecture 1 6/309
Scope of macroeconomics IWhat determines aggregate production/income.
US Real GDP growth and level
5019
5519
6019
6519
7019
7519
8019
8519
9019
9519
0020
0520
1020
http://www.Economagic.com/ Feb 18 2010-15
-10
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0
5
10
15
20
0
2000
4000
6000
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10000
12000
14000
average output growthGross domestic product: Real Gross Domestic Product, Chained Dollars: Billions of chained 2005 dollars; Seasonally adjusted at annual rateGross domestic product: Real Gross Domestic Product, Chained Dollars: Billions of chained 2005 dollars; Seasonally adjusted at annual rate
Green line: GDP level
Red line: GDP % growth rate
Blue line: average GDP % growth rate
Shaded regions: recessionsc© Giulio Fella, 2012 ECN 106 Macroeconomics 1 - Lecture 1 7/309
Scope of macroeconomics II
What determines the aggregate unemployment rate.
US Unemployment rate
5019
5519
6019
6519
7019
7519
8019
8519
9019
9519
0020
0520
1020
http://www.Economagic.com/ Feb 18 2010 2
3
4
5
6
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8
9
10
11 Unemployment Rate; Percent; 16 years and over; SA
c© Giulio Fella, 2012 ECN 106 Macroeconomics 1 - Lecture 1 8/309
Scope of macroeconomics IIIWhat determines the aggregate price level and its rate of
change (i.e. the rate of inflation).
US CPI Inflation
5019
5519
6019
6519
7019
7519
8019
8519
9019
9519
0020
0520
1020
http://www.Economagic.com/ Feb 18 2010-2.5
0.0
2.5
5.0
7.5
10.0
12.5
15.0 Consumer Price Index For All Urban Consumers: All Items: Index 1982-84=100: SA: percentage change from last period
c© Giulio Fella, 2012 ECN 106 Macroeconomics 1 - Lecture 1 9/309
Why we care about income
Income is an imperfect measure of economic well-being.
In the end what matters is utility, but:
I utility cannot be aggregated, in general;
I utility is unobservable and depends on variables out of the
realm of economics.
Utility, though, is increasing in consumption which is related to
income and wealth.
c© Giulio Fella, 2012 ECN 106 Macroeconomics 1 - Lecture 1 10/309
Why we care about unemployment
I If the workers who are unemployed could be engaged in
production, aggregate output would be higher (not
necessarily utility, though).
I Unemployment imposes financial and psychological strain.
c© Giulio Fella, 2012 ECN 106 Macroeconomics 1 - Lecture 1 11/309
Why we care about inflation
I Expected inflation (an anticipated increase in the aggregate
price level) increases the cost of keeping cash and results in
shoe-leather costs: e.g. more frequent cash withdrawals.
I Unexpected inflation redistributes welfare (e.g. creditors
lose and debtors gain if inflation is higher than expected)
and introduces uncertainty.
I Both are distortionary in the absence of indexation (e.g.
fiscal bracket creep).
c© Giulio Fella, 2012 ECN 106 Macroeconomics 1 - Lecture 1 12/309
How economists think
I Economists think using mathematical models.
I Models are abstract (simplified) representations of the realworld.
• Why mathematics? You can test your models!
• Why abstraction? The real world is too difficult to be
understood without simplifying it.
c© Giulio Fella, 2012 ECN 106 Macroeconomics 1 - Lecture 1 13/309
Economic models
I A model is a theory which tries to explain a relationship
among economic variables.
Example: demand and supply for wheat.
Qd = Income− bPQs = weather + cP
Qd = Qs
I Two kinds of variables:
• Exogenous variables: those which the model does not try to
explain (in our case income and weather)
• Endogenous variables: those which the model wants to
explain (in our case the P,Qs and Qd).
c© Giulio Fella, 2012 ECN 106 Macroeconomics 1 - Lecture 1 14/309
Economic models
I A model is a theory which tries to explain a relationship
among economic variables.
Example: demand and supply for wheat.
Qd = Income− bPQs = weather + cP
Qd = Qs
I Two kinds of variables:
• Exogenous variables: those which the model does not try to
explain (in our case income and weather)
• Endogenous variables: those which the model wants to
explain (in our case the P,Qs and Qd).
c© Giulio Fella, 2012 ECN 106 Macroeconomics 1 - Lecture 1 14/309
Model’s solution/equilibrium
Endogenous variables as a function of exogenous ones.
P = f(Income,weather)
Qd = g(Income,weather)
Qs = h(Income,weather)
For a solution to exist, we need at least as many equations
as endogenous variables.
c© Giulio Fella, 2012 ECN 106 Macroeconomics 1 - Lecture 1 15/309
The concept of cause
Only an exogenous variable can be a cause.
E.g. the statement the price is high because demand is high is
meaningless. Demand (the quantity demanded) is endogenous.
c© Giulio Fella, 2012 ECN 106 Macroeconomics 1 - Lecture 1 16/309
Measuring economic variables
I Aggregate Income/Production: Gross DomesticProduct
(GDP)
I Aggregate price level: GDP deflator and CPI deflator
I Unemployment: unemployment rate
c© Giulio Fella, 2012 ECN 106 Macroeconomics 1 - Lecture 1 17/309
Gross domestic product(the output or expenditure side)
The most used measure of aggregate production. It measures:
the value of the final goods and services
produced domestically in a given period =
= the sum of value added in the domestic
economy in a given period
value added = value of final production - value of intermediate
inputs
c© Giulio Fella, 2012 ECN 106 Macroeconomics 1 - Lecture 1 18/309
Avoiding double-counting
Cars Steel
Revenues: 400 Revenues: 200
Costs: Costs:
Steel 200 Raw mat. 100
Labour 100 Labour 50
Profits: 100 Profits: 50
Final production: 400
Value added: 200+(400-200)=400
c© Giulio Fella, 2012 ECN 106 Macroeconomics 1 - Lecture 1 19/309
Flows and stocks
I Stock: quantity measured at a point in time (e.g. water in
a bucket)
I Flow: a quantity measured over a period of time (e.g.
water through a pipe)
Flow variables in economics: GDP, investmest, saving, deficits.
Stock variables: wealth, capital, unemployment rate.
c© Giulio Fella, 2012 ECN 106 Macroeconomics 1 - Lecture 1 20/309
GDP and factors income (the circular flow)
Firms Households
Factors
Income £
Expenditure £
Goods and services
c© Giulio Fella, 2012 ECN 106 Macroeconomics 1 - Lecture 1 21/309
Factors income
The income of all productive factors:
I Labour income: wages
I Capital income:
• Income from rented capital: rentals
• Income from firm-owned capital: dividends and interest on
corporate bonds
c© Giulio Fella, 2012 ECN 106 Macroeconomics 1 - Lecture 1 22/309
Double-entry book keeping
How can the Income = Expenditure identity hold if some goods
are not sold within the period?
We must distinguish two cases:
I The good is storable: then the unsold quantity is accounted
for (at market prices) in expenditure as inventories (it is
treated as if the owners of the firm had bought the unsold
quantity)
I The good is not storable: it does not enter expenditure and
profits are reduced by the excess of costs over sales
c© Giulio Fella, 2012 ECN 106 Macroeconomics 1 - Lecture 1 23/309
Example
Market value of total output = 100
Nails
+ -
Sales 80 Raw m. 50
∆ Inven- Labour 20
tories 20 Profits 30
Ice cream
+ -
Sales 80 Raw m. 50
Labour 20
Profits 10
c© Giulio Fella, 2012 ECN 106 Macroeconomics 1 - Lecture 1 24/309
Expenditure (or product) and income side
Total final value of goods and services produced domestically =
Total domestic income
GDP can be measured from the income or the expenditure side.
The result has to be the same, barring accounting errors.
c© Giulio Fella, 2012 ECN 106 Macroeconomics 1 - Lecture 1 25/309
Aggregation
Problem in constructing an aggregate output measure (product
side): summing apples and oranges!
We need a common unit of account → convert everything into
currency by multiplying by prices
GDP = P1Q1 + P2Q2 + P3Q3 + ...
c© Giulio Fella, 2012 ECN 106 Macroeconomics 1 - Lecture 1 26/309
Real versus nominal GDP
What we want to measure is real GDP; i.e. the physical amount
of goods and services available. If all prices double, but
quantities are unchanged individuals are not better off.
I Nominal GDP: uses current prices. Increases with price
increases even if quantities are unchanged
I Real GDP: uses prices in a fixed base year.
Problem: the change in real GDP over time depends on the
choice of base year (it depends on relative prices).
c© Giulio Fella, 2012 ECN 106 Macroeconomics 1 - Lecture 1 27/309
In detail
Nominal GDP in year t =∑
i PtiQ
ti
Real GDP in year t at year j prices =∑
i Pji Q
ti
c© Giulio Fella, 2012 ECN 106 Macroeconomics 1 - Lecture 1 28/309
GDP and GNP
GDP measures the total income produced domestically whether
it accrues to factors owned by home or foreign residents.
Gross National Product (GNP) = total income earned by home
residents (both at home and abroad) = GDP + net factor
income from abroad
c© Giulio Fella, 2012 ECN 106 Macroeconomics 1 - Lecture 1 29/309
Price aggregation
I Aggregate price level: averaging prices of different goods.
I We want to measure the “cost of living”. Which weights to
use?
• Consumer price index (CPI): uses fix weights. Representative
consumption bundle.
• GDP deflator: the weights are the quantities produced
domestically in the current year (they change over time)
c© Giulio Fella, 2012 ECN 106 Macroeconomics 1 - Lecture 1 30/309
GDP versus CPI deflator
I CPI deflator: overstates changes in the cost of living as
individuals move away from items whose price increase.
I GDP deflator: nominal GDP/real GDP.
• It does not reflect that substitution away from goods may
reduce consumer welfare.
• Unlike CPI it takes into account increases in the price of
goods bought by firms or the government.
• It does not account for increases in the price of goods
produced abroad.
c© Giulio Fella, 2012 ECN 106 Macroeconomics 1 - Lecture 1 31/309
The unemployment rate
I Total labour force L = U + E
I U = Number of unemployed workers
I E = Number of employed workers
I Participation rate = L /total working-age population
I Unemployment rate = U/L
c© Giulio Fella, 2012 ECN 106 Macroeconomics 1 - Lecture 1 32/309